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The Fourth Wave

Are banks better at trading power than utilities?

Fortnightly Magazine - October 1 2002

they are going to have trouble answering.

"If you are going to use the term optimization. you are going to have to define the mathematical function that you are trying to either maximize or minimize. That is what optimization means. I think what they are saying is that they have the size, scale, and magnitude and wherewithal to deal with a lot of the [deal] customization in-house."

He bet that if I walked around the bank's sprawling trading floor, I would get a consistent answer as to what service or function the bank provides on the energy trading side. The general answer, he says, will be "We are in the business of providing price risk management services."

Indeed, that is typically the answer I get when I do ask.

Just what purpose does the energy trading function serve?

After energy companies were caught using energy trading as a means to boost revenues by booking unrealizable gains on questionable deals and round-trip trading, that's a reasonable question to ask. Investors and those outside the industry go further, and ask: Was it all a mirage?

The banker provides me with a back-to-basics explanation of one of the services he offers. "Do you know whether the Peach Bottom power plant is going to be available tomorrow? Let's say it is now May and it's going to be July-is it going to be ready?"

He asks, can I come to you and get a guarantee from you that power prices will not be above $30? "I'm a general public utility and I serve retail customers, and if power prices go up my earnings get squeezed terribly," he says. "Remember, I don't have a power plant, I sold my power plants and I don't have any backup power plant.

If Peach Bottom gives a guarantee, here is the problem for Peach Bottom.

"What happens if Peach Bottom goes down and it is not producing power? So it is not getting paid. Power prices go to $100. What does it owe? It owes the difference between $100 and $30 on the guarantee. It has this big cash flow out the door and no money coming in the door."

What the bank is going to do, he explains, is to make the guarantee to the retailer and stand in the middle, taking the risk. "We are taking a hedged risk. You can't make money without taking a risk. You are not providing a service to anybody unless you are taking the problem away. That is the problem that we take away," he says.

"The operator takes the problem of operating the plant away-such as the compliance risk with the Nuclear Regulatory Commission. The PJM operator takes away the hassle of operating the [grid] system. Everybody is doing their piece in this whole thing and this network of contracts arbitrates it. In my mind it is not any different than what you see in other businesses," he concludes.

Another wall street energy trader concurs that energy markets are really more financial than physical.

"The only real argument," he explains, "is